Oct 12, 2017

Why We're All Behavioral Economists Now

Because with the advent of sophisticated technology, vast reams of data and the ability to analyze as well as interpret it with greater accuracy, understanding not just what consumers and enterprises do but why they do it - has become essential to propelling the economy forward. JL

Erik Angner reports in Behavioral Scientist:

Behavioral economics tries to increase
the explanatory and predictive power of economic theory by providing it
with more psychologically plausible foundations - “the combined assumptions of maximizing behavior, market equilibrium, and stable preferences, used relentlessly." What behavioral
economists do instead is incorporate ideas drawn from
contemporary psychology.Behavioral economist Richard Thaler was awarded the Nobel Prize in Economic Sciences 2017. This makes him at least the third person working on behavioral economics to win the prize, after Herbert Simon in 1978 and Daniel Kahneman in 2002.Behavioral economics has long defined itself, in part, in opposition to standard (neoclassical) economics. This was as true of Simon in the 1950s as it was of Kahneman and his long-time collaborator Amos Tversky in the 1970s and thereafter.But recently something has changed. Now, neoclassical and behavioral economists alike often go out of their way to downplay the differences.What happened? What is behavioral economics, and how does it differ from neoclassical economics? Is there a difference at all?What I’m calling standard, or neoclassical, economics is social science in the tradition of 1992 Nobel laureate Gary Becker, who wrote, “The combined assumptions of maximizing behavior, market equilibrium, and stable preferences, used relentlessly and unflinchingly, form the heart of the economic approach as I see it.”Like Becker, many standard economists identify their approach to economics with economics, full stop—so that those who reject the assumptions don’t even count as economists. If you’ve studied economics in college and don’t know what kind it was, it’s almost certain that it was neoclassical economics.Every component of Becker’s economic approach has come under fire from behavioral economists, generating a spirited debate going back at least half a century.

Recently something has changed. Neoclassical and behavioral economists alike often go out of their way to downplay the differences.

But recently many standard economists have adopted a more conciliatory tone. Consider Stanford University Economics professor Raj Chetty’s prestigious Ely Lecture at the American Economic Association in 2015 (Chetty was then at Harvard University). Chetty began his lecture by noting that debates about behavioral versus neoclassical approaches have often concerned more or less philosophical foundations—including Becker’s three assumptions. Chetty evidently has little patience for that sort of discussion. He writes:“In this paper, I approach the debate on behavioral economics from a more pragmatic, policy-oriented perspective. Instead of posing the central research question as ‘Are the assumptions of the neoclassical economic model valid?,’ the pragmatic approach starts from a policy question… and incorporates behavioral factors to the extent that they improve empirical predictions and policy decisions.”Chetty clearly wants to bypass the foundational issues, in order to get on with the policy questions that concerns him. This is fair enough: In actual scientific practice, explicit discussion of philosophical foundations is often a distraction.Instead, his “pragmatic approach” suggests that standard economists can borrow freely from behavioral economics as appropriate and necessary to predict, explain, and inform policy decisions—without first taking a stance on the foundational stuff.Chetty expresses well the typical mainstream economist’s attitude to behavioral economics these days.The attitude feeds into a narrative according to which behavioral economics is “doomed.” Here’s the argument. Some of the effects that behavioral economists have studied cannot be replicated, or are already consistent with standard theory. Other effects can be—and in many cases already have been—successfully incorporated into standard economics. Therefore, the argument concludes, behavioral economics as a stand-alone research program is over.In reality, however, Chetty’s “pragmatic approach” is just behavioral economics.Behavioral economists have never been opposed to all uses of standard theory. As Matthew Rabin said, “[Behavioral economics] is not only built on the premise that mainstream economic methods are great, but also that most mainstream economic assumptions are great.” This may strike the casual observer as puzzling. But practicing behavioral economists use standard theoryfor all sorts of purposes—in much the way that the manner of what the great sociologist Max Weber called an ideal type.What, then, characterizes the behavioral approach? Well, by definition, behavioral economics tries to increase the explanatory and predictive power of economic theory by providing it with more psychologically plausible foundations. Getting rid of neoclassical theories, methods, and assumptions when they work would amount to throwing out the baby with the bathwater. What behavioral economists do instead is to incorporate ideas drawn above all from contemporary psychology when necessary and appropriate.But this is the exact procedure that Chetty advocates. Far from showing that behavioral economics is doomed, or that behavioral economics as a stand-alone research program is over, Chetty represents the consummate conversion of neoclassical economists into behavioral ones.In the mid-60s, Chicago economist Milton Friedman coined the phrase “We’re all Keynesians now.” Half a century later, we might say instead: “We’re all behavioral economists now.”

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As a Partner and Co-Founder of Predictiv and PredictivAsia, Jon specializes in management performance and organizational effectiveness for both domestic and international clients. He is an editor and author whose works include Invisible Advantage: How Intangilbles are Driving Business Performance.Learn more...